The theme for the last 6 months has been a divergence in fundamentals between bullish corporate data and a bearish macro climate. The trend continues.
Fueling the stock rally of the last month have been rumors that many companies are on the verge of increasing dividend payouts and share buybacks. Large US companies are sitting on lots of cash. Many halted share buybacks and held off increasing dividend payouts to be conservative in the dangerous economic climate. As optimism returns and their cash piles grow, they will soon start returning money to shareholders in various forms. Investors are rightly taking this as bullish for stocks. Also, the stock markets of some strong developing countries like Israel and Argentina are setting new all-time highs. Inflation has remained under control, and interest rates are stable.
We’ve simultaneously been getting bearish macro data. Home prices and sales have resumed their downward decline and consumer sentiment dropped slightly. Germany seems to have taken a stand against bailing out Greece and is looking to introduce measures that will make it easier to kick the next crisis country out of the Eurozone. Basic measures of economic activity like the Baltic Dry Index (a measure of international shipping activity) and US freight volume have turned down. None of these measures are collapsing, but they appear to be (at least temporarily) stagnating; they undermine the idea that we’re in the midst of a robust recovery.
My basic thesis is unchanged; corporations are generally healthy because their debt has been transferred to the government. Households are in terrible shape, and the government’s balance sheet is in terrible shape. Below is a graph of transfer income as a percentage of total income – it shows that the resilience in the US consumer may be due to a 4% increase in government “gifts” to the consumer over the last few years. Consumers spend that money and companies seem to prosper, but of course it’s not a free lunch. At some point the “gifts” either create inflation, crowd out productive investment, or lead to a crash when the government eventually tightens credit.
A note on the recently passed healthcare bill: Serious investors believe it adds roughly half a trillion dollars to the US debt over the next decade. It also will certainly self-destruct since no rational healthy person would pay for insurance when you can get insurance on your way to the hospital for the same price as a healthy person (by law), and the penalty for being uninsured is a paltry $750 or 2.5% of income. Drastic changes must be made to the bill for it to work at all, and at some point, we really will have to bend the cost curve down to avoid bankruptcy as a country. There still isn’t the political will for the obvious technocratic fixes like tort reform and ending state insurance monopolies.
This is the second essay in the "economic fundamentals" series and tackles inflation. The greatest economists disagree about the nature of inflation. I will not attempt to settle the debate here, but rather to explore the dominant perspectives. My premise is that most of the perspectives on inflation are not mutually exclusive, but rather represent different interpretations of a chaotic reality. By applying many different lenses to the current economic climate we will gain a more thorough understanding than with any single lens. A big part of our job as investors is to find the intellectual tool that best fits the job. To that end, I’ve structured this essay as a debate with many voices. Most of the ideas here come from the great economists Hayek, Keynes, and Friedman, but I am also indebted to the more modern economists John Hussman and Paul Krugman. Those of you with a strong background in economics might want to skip to section #3.
Inflation is a persistent and widespread increase in prices. If a currency is suddenly devalued causing all prices to double, this is not inflation. Inflation requires a dynamic of persistent price increases over time. Once inflation takes hold, it is naturally self-sustaining. If consumers expect that prices will continue rising, they will make their purchases as soon as possible to avoid the higher future prices; this causes the velocity of money to rise and increases the immediate demand for goods, fulfilling the prophecy of higher prices. The additional demand causes corporate revenues to rise and workers demand raises; the higher wages similarly lead to higher demand and higher prices and further wage hikes.
At its core, inflation is simply a question of supply and demand. Prices of goods are set where supply meets demand. If demand for goods increases faster than supply, prices will rise. One trigger for inflation is a supply shock. For example, in the Gulf War, the world’s oil supply was decreased while demand was unchanged. This caused oil prices to rise until demand was reduced to meet the new lower supply. The rise in oil prices led to higher prices for all the many products that are directly and indirectly made from oil including fertilizer, gasoline, and steel. Supply shock inflation is less frequent and generally less lasting than demand driven inflation.
More commonly, inflation is driven by an increase in aggregate demand. Aggregate demand is a measure of the total demand for goods and services throughout the economy. It can increase for many reasons. If the Federal Reserve prints new money, more money will now be chasing the same quantity of goods. Financial innovation (e.g. ATM machines, complex derivatives) may increase the velocity of money, which is very similar to the printing of new money. An increase in general optimism or “animal spirits” may cause businesses to spend more on investment and consumers to increase consumption. Finally, an increase in government spending may compete with private demand for goods and push prices higher.
Milton Friedman claimed that “inflation is always and everywhere a monetary phenomenon.” Friedman was deliberately oversimplifying, but he believed that most inflation is caused when the money supply increases faster than the supply of goods.
For much of human history, the money supply increased when new precious metals were mined. More recently, central banks introduced fiat money (i.e. paper currency) and controlled its supply. Friedman argued that modern inflation was usually caused when the central bank increased the money supply too quickly. This can happen with the literal printing of money, with open market operations whereby the Federal Reserve purchases government debt from banks, or from a reduction in reserve ratios or interest rates. Complicating this view are the numerous examples of money printing that did not result in inflation (i.e. Japan), how to measure the money supply, and savings versus investment, and productive versus unproductive spending. I’ll revisit all of these issues.
What causes inflation?
John Hussman argues that it’s not new money that primarily causes inflation, but unproductive government spending. This is a critical and uncommon view. If the new money is used to pay down debt (either private or public), the deleveraging does not necessarily cause inflation. I’ll illustrate this concept with an example: The government borrows $100 from private citizens and spends that money purchasing asphalt to build roads. Let’s say the citizens were previously keeping the $100 under their mattress in cash. The citizens feel equally wealthy as before (they still have $100 saved), but there is an extra $100 of demand for goods because of the government borrowing. Now the Federal Reserve prints $100 and uses it to buy the government’s debt from the private citizens. Once again the citizens have $100 in cash, but demand neither increases nor decreases. In other words, the increase in demand (and possible inflation) was caused by the government spending, not the Federal Reserve’s money printing.
Hussman concludes that we should focus on demand, not the money supply. Government borrowing may increase aggregate demand and money printing may not. This is a complex framework since it matters greatly who buys the government debt and under what circumstances. In my example, citizens purchased the debt with cash that was otherwise hidden under a mattress. If instead it was banks purchasing the government debt under normal economic conditions, the government debt would likely displace private borrowing and would not increase aggregate demand.
To continue the discussion of the effects of government spending, let’s turn to Keynes. Classical economics argued that investment must equal savings. When the government borrows money, classical economists argued that the government would “crowd out” private borrowers since they’re drawing on the same pool of savings. The mechanism for this crowding out is higher interest rates. Keynes disagreed. Keynes argued that investment was more dependent on long-term profit potential and “animal spirits” than the supply of savings. Keynes recognized that the link between savings and investment was tenuous at times. Savings may sit useless with a bank that is too scared to make new loans or it may be multiplied many times through the fractional reserve banking system. During recessions, demand for investment drops below the supply of savings and therefore the government doesn’t crowd out much borrowing with its spending. Keynes argued that the government’s spending may be unproductive, but it’s still better than nothing. He said that it might be prudent for the government to deliberately break a window and then hire someone to repair it, as long as the repairmen would otherwise be unemployed.
What about the relationship between inflation and unemployment? One of the biggest misconceptions in modern economics is based on the Phillips Curve. The mistaken view is that the there is a direct trade off between inflation and unemployment, and that by increasing inflation we decrease unemployment. The flip side of this is the argument that as long as unemployment is high we are unlikely to get inflation. First of all, the historical data does not support either claim. While there is certainly a relationship, it is not at all direct. Rather, the Phillips Curve shows the relationship between the employment level, and real wage increases. When unemployment is low, wages will increase faster than the general price level. If most prices are falling by 5%, wages may only fall 2%. Wages are a key component in the general inflation level, but there are many other factors to consider.
Hayek explained that it’s not inflation that causes unemployment to decrease, but rather the unexpected increase in inflation. This is because an unexpected increase in inflation causes revenues to increase unexpectedly and produces greater profits. Over the long run, these profits are not real because they must be spent on more expensive capital and material inputs. In the short run however, they lead to an increase in aggregate demand and thus make businesses and consumers feel wealthier. As soon as inflation expectations match inflation, the higher interest rates eliminate the excess profits.
We’re faced with a handful of very different sources of inflation. To summarize:
Inflation may be caused by…
an increase in the base money supply
an increase in total money (taking into account the velocity of money)
an increase in total money + debt (taking into account leverage)
an increase in aggregate demand
an increase in unproductive demand for goods
an increase in inflation expectations
a decrease in economic slack (e.g. unemployment)
None of these are mutually exclusive, but by emphasizing one element over another, we may come to a very different conclusion about the current risk of inflation. In the last few years, the base money supply has more than doubled and government debt and spending have dramatically increased, but other sectors of the economy have been deleveraging and the velocity of money has collapsed. Inflation expectations remain moderate, and there is plenty of slack in the form of unemployment and excess manufacturing capacity.
Ultimately, we know that inflation’s root is higher demand relative to supply, so I think it makes sense to bring everything back to that. Every view discussed above is right at least some of the time, but it’s right because under particular conditions it will lead to a sustained increase in aggregate demand. Our job is to judge how aggregate demand will react to a change in leverage, inflation expectations, unemployment, and all of the other factors discussed above. To accomplish this we need a thorough understanding of how the potential inflationary inputs act on aggregate demand. Hopefully this discussion has been a small step toward that understanding.
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Alpha is an investor and an entrepreneur. Ari is a proprietary derivatives trader. The views here are personal to the authors and do not represent the views of any other individual or organization.